What is the difference between salary and dividends?

What is the difference between salary and dividends?

Business owners often wonder what the difference between salary and dividends really is. This is because many of them know that the most tax efficient way for a director to pay themselves is with a combination salary and dividends.

We think that one of the key decisions that business owners have to make is how to pay themselves. The two main options available for those who have moved to a limited company structure are salaries and dividends. While both methods have their own advantages and disadvantages, choosing the right one can make a big difference to the financial health of the company and its owners.

But what is the difference between salary and dividends and more importantly is there a risk?

What is the difference between salary and dividends?

A salary is the fixed amount paid to an employee on a regular basis. It is subject to income tax and national insurance contributions (NICs).

Dividends are payments made to shareholders out of the company’s profits after corporation tax has been deducted. They are subject to income tax, but not to national insurance contributions (alos known in short as NICs).

Dividends are paid out in proportion to the number of shares the shareholders hold in the company. There is no requirement that 100% of the profit has to be paid out in the form of dividends.  Profits can be retained in the company and paid out at a later date, or used to purchase assets, repay loans, etc.

What are the benefits of taking a salary ?

There are significant benefits of taking a salary:

  • Builds up the qualifying years for the state pension
  • You can take a salary even if the company is making a loss
  • It can make it easier to apply for mortgages etc
  • Since salary is an allowable expense, it will reduce the company’s corporation tax liability

How do you decide how much salary to take? 

The starting point when deciding the director’s salary is to check what the tax free personal allowance for the current financial year is. This is because you don’t pay personal tax on your earnings until you pass the tax free personal allowance threshold of currently £12,570 (2023/24). However, National Insurance is payable once your income passes the primary threshold which is currently aligned with the tax free personal allowance for income tax which is £12570 per year for 2023/24 (this translates to £242 a week or £1,048 a month).

But in order to get the state pension qualifying years, the salary must be over the lower earnings limit which is currently £6,396.

Therefore sole directors tend to set their salary between the lower earnings limit and primary threshold, and then take the remainder of their income in dividends.

What are the benefits of taking dividends? 

There are significant advantages of taking dividends:

  • Dividends are taxed at lower rate than a salary
  • They do not attract National Insurance liabilities for either the employee or the employer
  • There is a tax free dividend allowance of £1,000, which is in addition to the personal tax free allowance of £12,570.

Are there risks of taking dividends?

There are some risks associated with taking dividends that are worth noting:

  • Dividends are not a tax deductible expense
  • Dividends can only be paid if there is a profit for the year or if retained reserves are available
  • Your income can be unpredictable when relying heavily on dividends.
  • If at year end there is not enough profit to cover the dividends that have been taken, these will be classed as a Director’s loan and will need to be paid back to the company or taxed.

What is the right mix of salary and dividends?

The right mix of salary and dividends will depend on your target income, the amount of cash and distributable reserves generated in your business and the tax planning strategy. This is why it is essential to review your income in line with the latest changes in legislation, including:

  • Corporation Tax has increased from 19% to 25% starting 1 April 2023. The 19% rate will still apply if the company’s profits are £50,000 or less per year, but more tax will be paid on profits above this level. Companies with annual profits of £250,000 or more will pay the full 25% rate, while between the two rates, a system of marginal relief will apply.
  • Dividend Allowance has decreased from £2,000 to £1,000 starting 6 April 2023.
  • The threshold for the highest rate of income tax (45%) has reduced from £150,000 to £125,140 per annum starting 6 April 2023.

How can LAS Accounting help?

What the difference between salary and dividends is deserves your full attention and we are here to relieve you of this burden. During our initial meeting we will discuss your specific circumstances and work out the right salary mix for you and your business. It could be that that mix changes as your business grows and becomes more stable.  It could also depend on how many directors and employees you have.

At LAS Accounting we also monitor your figures quarterly as part of our quarterly reporting as standard, so we can keep an eye on your dividend levels to ensure you don’t take more than you have in profits (after corporation tax will have been deducted).  We can then adjust the salary vs. dividend mix so we can stop you taking too much before it becomes an issue.

If you want to know more about how we can help you get the right salary to dividend mix, or any part of your accounts, pop over to our Contact Page.  Complete the quick questionnaire, and we will be in touch with you to arrange a discovery call.

 

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